Monday, December 6, 2010

At the height of the real estate bubble in the United States in 2006, housing starts peaked at an annualized rate of 2.2 million units. For the past two years or so, they have held at about 600,000, that is, less than one third the pace of the heydays. Unfortunately, the latest available data do not indicate an improvement in the situation. On the contrary, the level of activity sank to its lowest mark since April 2009.

The problem is that oversupply from foreclosures on the resale market is cramping out the new-homes market. In this regard, though they remain high, defaults and loans in foreclosure have trended down for two quarters, which suggests that the worst has already happened.

Furthermore, we are not discounting the possibility of pentup household formation in the United States attributable to the difficult economic context. At a time when the economy is beginning to create jobs again and that housing has never been more affordable, especially following the second wave of quantitative easing, a rebound in housing demand should not be ruled out.

However, we must not kid ourselves: It will be a good while still before the damage provoked by this crisis is repaired. The housing vacancy rate in the United States will need to come down substantially before we see a notable improvement in residential construction. With household formation at 1.2 million and housing starts at 0.6 million, it would take almost three years to redress the situation. In other words, 2011 will not mark the revival of residential construction in the United States.

Long period of atonement
It has been four years now since home prices began falling in the United States. The decline was a harbinger of what turned out to be the worst economic crisis since the Great Depression. Homebuilders were certainly guilty of excess optimism, but the extent of the drop in housing demand reflected much more the deterioration of the labour market. What’s more, the upsurge in defaulted loans brought a flood of foreclosures on the market, thus inducing a state of paralysis in construction activity. As a result, it has been a long period of atonement for homebuilders. But are the bad times finally drawing to a close for them?

No rebound whatsoever
In order to analyze the present recovery, we often evaluate how much of the activity that prevailed before the
crisis has been regained in the different sectors of the economy. In the case of residential construction, the
recovery has been marked by no rebound whatsoever. Indeed, activity has stood at an annualized rate
of about 600,000 units for nearly two years now, that is, less than one third the peak registered in 2006. Moreover, the October data are far from reassuring, as the level reached was the lowest since April 2009.

As a result, the share of the economy accounted for by this sector has shrunk to an unprecedented level since
record-keeping began. Such a phenomenon even leads economists to lose interest, seeing how it will take a
notable improvement in the situation before the sector will again have a major impact on economic growth forecasts.

Handing keys over to creditors
While there is no denying the collapse in housing demand, we cannot overlook the skyrocketing defaults that led to a huge number of foreclosures entering the resale market. The highest delinquency rate for residential mortgages previously recorded was 6.1%. At the start of 2010, this rate peaked at 10%. Fortunately, the delinquency rate has been on the decline now for two quarters, which suggests that the worst has already happened in terms of defaults. Foreclosure starts did increase in the third quarter, but this actually reflected earlier defaults.

Despite this jump in foreclosure starts, total loans in the foreclosure process, instead, have decreased slightly,
which means that the worst has probably already occurred for the resale market as well. The fact remains, however, that the number of homes to be sold by creditors entering the market is still quite considerable.

In order to gain a better idea of the latest trend in loan delinquency, let us take a look at loans that are less than 30 days past due. Historically, these have correlated strongly with initial unemployment claims. As it turns out, claims were back on the right track trending down again in the third quarter. While layoffs were decreasing, claims had been on the rise since the beginning of the year. This suggested we could expect a wave of strategic defaults that would further deteriorate the situation in the residential real estate sector.

Resale market absorption
How, then, is the home resale market faring? At first glance, the situation might seem worrisome. Indeed, the
number of months of supply has veered upward again recently and still exceeds 10 months of sales. Not long
ago, at such an inventory level, home prices fell drastically.

What is less of concern is the fact that the weakness is predominantly on the demand side. This is because
demand can be expected to bounce back in the coming months. Indeed, in view of the end of the tax credit for first-time homebuyers, many people purchased homes ahead of time before the program expired. The resale market is presently paying the price for this. Consequently, it is not unreasonable to believe that sales
will soon return to their average level since 2008.

Pent-up demand
Moreover, it is highly likely that there is some pent-up household formation around nowadays. It turns out that
household formation is very cyclical, as illustrated in Chart 8. Indeed, economic uncertainty slows household
formation which was listless from 2007 to 2009. However, the rebound witnessed in the past year is reason to be optimistic, all the more so now that the economy has begun creating jobs again, as suggested by the October labour data.

Furthermore, housing affordability is at an unprecedented level, as evidenced by the qualifying income needed to buy a home nowadays. At the height of the housing bubble, one needed to be earning almost 100% of the
median income in order to qualify. Today, less than 60% of the median is required.

Second wave
The second wave of quantitative easing has already rendered the housing market more affordable and should
continue to do so even further with time. This should contribute to correct the situation as well. In addition, we
expect to see an increase in mortgage refinancings. This is because, so far, in spite of a loans volume nearly 70% higher than in 2002, mortgage refinancings have remained relatively low.

The fact is that, until June 2010, the differential between the market rate on mortgage loans and the effective rate that prevailed in recent years was not wide enough to cause a huge wave of refinancing as occurred in 2002-2003. Since the second wave of quantitative easing has been in the economic picture, mortgage rates have come down substantially. The differential is such right now that it should be conducive to a groundswell in mortgage refinancings. We believe that this easing of the debt load might convince a certain number of households to resist the temptation of strategic default.

More patience called for
So far, we have focused solely on the resale market in estimating oversupply in the housing market. However, to gain a better idea of what awaits homebuilders, we would do well also to take a gander at the rental market. As it happens, the vacancy rate in this market is very high as well. Combining the dwellings for rent and the houses for sale that are vacant, we obtain a vacancy rate for the U.S. housing sector as a whole. This rate today stands at roughly 5%.

Chart 12 shows the extent to which housing starts have been contingent upon the vacancy rate on a historical
basis. We are of a mind that this rate will need to come down to about 3.6% for building activity to return to an interesting level. A drop of 1.2 percentage points in the vacancy rate would translate into the absorption of 1.6 million dwellings. With household formation at 1.2 million and housing starts at 0.6 million, it would take almost three years to redress the situation. In other words, 2011 will not mark the revival of residential construction in the United States.

Conclusion
Activity in the residential construction sector is at a low. Oversupply from foreclosures on the resale market is
cramping out the new-homes market. In this regard, though they remain high, defaults and loans in foreclosure
have trended down for two quarters, which suggests that the worst has already happened.

The present imbalance in the resale market could ease quickly in that we are currently witnessing the repercussions of the end of the tax credit for first-time homebuyers. Furthermore, we are not discounting the
possibility of pent-up household formation in the United States attributable to the difficult economic context. At a time when the economy is beginning to create jobs again and housing has never been more affordable, especially following the second wave of quantitative easing, a rebound in housing demand should not be ruled out.